Cash flow forecasting: “The Art and the Science”

At the best of times, cash flow forecasting can be tricky, and as companies now feel the economic impacts of COVID-19, improving cash flow management is front and centre. Resource scarcity, turbulent financial markets and a general sense of economic uncertainty have given rise to the urgent need for companies to effectively - and cautiously - manage their cash. As such, accurate cash flow forecasting today has become more important than ever, yet at the same time, it has become even more challenging to undertake as a result of high levels of uncertainty.

So, to assist finance and treasury functions undertaking cash flow forecasts during this difficult time, we decided to put our pen to paper and provide a simple forecasting refresher to everyone as they gaze into the crystal ball.

What is cash forecasting?

Cash forecasting is the process of identifying short, medium and long-term liquidity requirements to effectively manage liquidity risks and add value to the organisation or company.

While this sounds highly beneficial on the surface (and it is), there can be significant time and effort are required to produce and maintain good, accurate and useful cash flow forecasting data, so it needs to be a deliberate exercise.

During periods of certainty and abundant liquidity, where cash is plentiful, a view adopted by some organisations is that the cost and time required to deliver an accurate forecast is hard to justify, with some pushing the view that the cost or benefit analysis doesn’t make it worthwhile.

As a result, we are now seeing a mix of cash flow forecasting practices in the market with even some organisations - who must maintain cash flow forecasting as part of their Australian Financial Services Licences - having underinvested in their cash forecasting capability resulting in highly manual, inconsistent and often inaccurate processes. This can result in a dangerous situation if the C-Suite and Board are using inaccurate forecasts to forensically understand the cash needs and burn rate of organisations to ride through a crisis such as the one that we find ourselves now.

Forecasting 101

A reliable cash forecasting process is considered by many to be essential for effectively managing liquidity risk. When planning a timescale, companies must have an understanding of the funding required for a range of potential scenarios. More importantly, it must know which levers to pull or push in a disrupted economy to manage and maintain liquidity and fund its operating, investing and financing cash flows. Therefore, by predicting shortfalls and surpluses, managers can optimise the use of cash and facilities by the company to improve investment returns, negotiate better borrowing terms and conditions as well as minimise external borrowing.

For cash management purposes, there are usually three timescales for forecasting, each serving a different purpose:

Short-term: Daily and generally up to 30 days where the forecast is prepared by day and by week

Medium-term: One month (or the end of the short-term forecast) to one year, where the forecast is prepared by month

Long-term: Over one year, where the forecast is for one or more years. However, depending on the company or organisation, it is also useful to have quarterly or half-yearly forecasts.

Understanding long-term forecasts

The objective of a long-term forecast is to identify structural cash shortages and surpluses (including requirements for committed facilities). This is achieved by identifying the potential impact of strategic initiatives or business changes on a company's:

Long-term liquidity and cash flows

Capital structure

Balance sheet

Credit ratings

Leverage ratios (if applicable).

Potential investors, often require long-term forecasts to ensure that sufficient cash is being generated so the company can continue to make loan and interest payments on long-term debt without risking other business activities.

Understanding short-term forecasts

Short-term forecasts are used to manage day-to-day cash requirements by identifying the amount and timing of expected cash receipts and payments.

The objectives of short-term forecasts are to:

Ensure there is sufficient liquidity to meet all short-term obligations and avoid the need for expensive, unanticipated overdrafts or other emergency funding;

Put short-term surpluses to optimal use by ensuring that there are no idle balances sitting in non-interest or low-interest-bearing accounts;

Optimise liquidity across the company – ‘the right amount in the right place at the right time’;

Generating short-term forecasts enable the finance department to determine what funds are required in advance, giving the person managing the cash accounts time to:

Look for surpluses from other parts of the group that can be used (in some cases, inter-company loans can be used to fund shortages)

Look for the cheapest source of funds available in the market to bridge the gap

Enter the market when terms and conditions are most favourable

Ensure adequate facilities are available when required.

If the company is put in a situation where it must produce liquidity at short notice, the cost of these funds may be higher as well as difficult to obtain in certain markets.

Most of the time, intra-group funding - practised by most large groups - is more effective if it is based on forecast positions rather than as a reaction to short-term situations. The use of forecasts can also minimise the number of unnecessary transfers. It is still important to remember however, that transferring money across borders can be expensive – especially for daily cash management - and time-consuming.

In addition to this, short-or medium-term cash forecasts can and should also be used in foreign exchange (FX) risk management. In this context, a company can produce both local currency and foreign currency cash forecasts, so that finance and treasury can identify the size and timings of currency flows. This helps companies to:

Determine any remaining exposure and whether to hedge them in the FX market

Pool surplus or fund deficits across the organisation to optimise utilisation of cash.

Potential cash forecasting challenges and how to fix them

There are several challenges associated with generating a cash forecast. This is not surprising as many people consider accurate forecasting to be one of the most difficult elements of cash management.

Some of the main reasons why cash forecasting is so difficult are:

The age-old debate about profit v generation of cash.

Internal communication and respect of the cash flow forecasting end to end value chain;

Systems challenges;

Data quality and integrity issues; and

Resource challenges – such as lack of expertise on how to develop a forecast.

Therefore, for a cash forecasting system to work successfully, all business units must understand the importance of forecasts and buy into the process. Infrastructure companies also require maintenance of accurate project cash flows and feed that information to the finance team so that funding for projects is taken into account.

All these require clear communication and, frequently, an education process to ensure that the preparers of forecasts have the necessary information from other business units available as well as the confidence that other business units are accurately maintaining their data.

Many companies refrain from investing in tools and purpose-built computer applications to carry out these forecasts as efficiently and accurately as possible. Therefore, it is no surprise that excel spreadsheets seem to be the most common cash flow forecasting tool.

While there are many benefits of spreadsheets - notably their simplicity, accessibility and widespread use which makes them a simple solution for finance teams to provide information – data integrity issues can arise if they are not effectively controlled and managed.

Finally, the old saying of ‘garbage in, garbage out’ is key in this process. Like all reporting, cash flow forecasting is only useful if the data being used in the first place is accurate and regularly updated and refined.

So, should companies undertake regular cash forecasting?

Cash forecasting is an invaluable tool for companies, but only if it is tailored to meet the specific needs of the company undertaking the forecast and is:

Timely (and regular)

Prepared using reliable base data

Ensures backtesting over time to improve accuracy.

This will ensure that the time and money cost of preparing each forecast is justified and that the forecasts are delivering value to the company and its key decision-makers. For many businesses experiencing disruption right now and are looking to improve the accuracy of their forecasting, identifying and managing the levers to optimise liquidity; speaking to an adviser with expertise in cash flow management and forecasting will be vital for ensuring that not only do you have the valuable forecasting information, but also tailored cash flow management strategies to help you improve your cash flow position and the viability of the business.

Should you require further general information about cash forecasting and how it can help your company or organisation, please contact your local BDO office.